Q: I've been investigating a number of franchises, and they don't seem to be very consistent in terms of rate of return on investment. In fact it sometimes appears that there is very little correlation between the total investment and the amount of money I can make in the business. Is there a rule of thumb that applies to ROI in franchise opportunities?
A: This is a great topic, because the real answer is so counterintuitive for most people to accept. When you think of investing in real estate, the stock market or other somewhat passive investments, there is usually a fairly direct correlation between the amount invested and the total return. Returns of 10 to 20 percent per year on invested capital are normally considered very good.
Most people intuitively understand that the more you invest, the more you'll get back. "Spend more, get more" is an accepted fact of life. The problem is that this "fact" just isn't usually true in franchising.
The flaw in applying this same logic to franchising is that the investment is normally not passive. In addition to your capital, you are investing a fair amount of your time and management talent as well. You should be able to achieve a good return on both investments. Therefore, since you are making two investments, when you look at ROI in franchising, it should be considerably higher than what you can earn in a passive vehicle.
Returns in franchising vary all over the board. In most cases, the return (expressed as a percentage of the total investment) is usually smaller on high-investment franchise opportunities than on low-investment opportunities. The reason has everything to do with leverage.
You make two types of investments in a franchise opportunity. The capital you invest is static, and the returns you will earn on your invested capital are normally reasonable by passive investment standards. In other words, in most franchise businesses you will get very little leverage in relation to your capital investment. Even if you use debt to increase leverage, your debt service will simply decrease the overall net cash return produced by the business.
The real opportunity for leverage in franchising relates to the investment you're making in your time and talent. This is where a great franchise system can utilize this asset to increase your returns dramatically.
The franchisor develops a system or method of operation that employs the franchisee's time in a manner that drives the income from the business to levels that are not available from an investment of capital alone. These are the systems where a good operator can create annual incomes greater than 100 percent of the total initial franchise investment within a short period of time. That's effective leverage!
As a general rule of thumb, you should never invest in a franchise unless you believe (based on your own investigation) that the average annual income return from the business will be equal to at least 30 to 50 percent per year of the total initial investment for the franchise unit. The total investment we're referring to includes all debt and working-capital reserves needed to start the business.
If the return isn't at least this high, what are you working for? You'd be better off to keep your job and invest your capital passively.
So how do you find a franchise with great returns? The first answer is not to look at the most expensive opportunities. You want to find the ones with great management leverage. These are often franchises with total investments of less than $200,000 and, in some cases, less than $50,000. Diamonds often come in small packages.
The next step is to carefully investigate the average earnings of a typical unit during the first three years of operation. Make sure you know what the average performance is, not just what the best units can achieve. If the business is not making the returns by the third year, at the latest, keep shopping. There are plenty of great opportunities out there that will meet or exceed this standard in a relatively short time frame.